Reading: Introduction to Financial Analysis
1. Introduction
Important management decisions require a profound understanding of the firm and its competitive environment. To this end, the firm's financial statements constitute an important source of information. Using these statements, financial analysts tyically compile a set of financial ratios to quicky assess the financial health and prospects of a firm.
Ultimately, we want to understand how well the firm "performs" and what contributes to that performance. To get a comprehensive picture, we therefore have to look at the various determinants of firm performance (from a financial point of view).
Our first task is to make sure we understand the available financial statements. Because these statements are expressed in absolute values (dollars, pounds, euros, etc.), the numbers they contain are difficult to compare. To secure easier comparison, financial analysts therefore often compile so-called common-size financial statements: They express all the items of a statement in percent of a main value driver (e.g., assets or sales). These are the first two steps we take.
Then, financial analysts typically compute ratios to get more detailed information about the following dimensions of "performance:"
- Liquidity: Provides an overview of the firm's ability to cover its short-term liabilities.
- Activity: Shows how efficiently the firm manages its assets (and how quickly it converts these assets into cash).
- Asset structure: Provides information about the maturity of the firm's assets and whether that maturity matches with the maturity of the financing policy.
- Debt financing: Sheds light on the firm's financing policy as well as its ability to service the contractual debt obligations.
- Profitability: Measures the firm's ability to generate profits.
Making performance comparisons
Clearly, performance is a relative concept. To see this, consider a hypothetical firm that has managed to grow its sales by 10% over the previous year. Is a sales growth of 10% a good or bad result? Without a reliable benchmark, this question is very difficult to answer. To find an answer, we could compare the firm's sales growth with that of other companies over the same period. Alternatively, we could compare it to the firm's past sales growth rates:
- Comparison across companies: Measure firm performance relative to the best, the average, or the typical performer in the so-called peer group. If similar firms achieved growth rates of more than 10%, the performance assessment of our hypothetical firm might not be very favorable. Conversely, if most similar firms failed to grow their sales, our hypothetical firm performed comparatively well.
- Comparison over time: Measure firm performance relative to the same company at a different point in time. In our case, the hypothetical firm's historical sales growth rate could provide a benchmark to assess its current growth.
Absolute values (in $, £, EUR, etc.) are difficult to compare. For example, consider Ford and GM. Ford Motors has generated Earnings Before Interest and Taxes (EBIT) of 8.56 billion in 2015. In comparison, GM's 2015 EBIT was only 5.35 billion. Did Ford actually do better than GM? Or is Ford simply bigger? We cannot tell.
To find an answer, we have to normalize the earnings figures. The following sections will do so in various ways. For the purpose of illustration, let's simply normalize the earnings figures with net revenues. This will yield the so-called EBIT margin.
The net revenues of Ford and GM were 150 billion and 152 billion, respectively. Therefore, with each dollar in net revenues, Ford has generated an EBIT of 5.7 cents [= 8.56/150]. In contrast, GM has only generated an EBIT of 3.5 cents per dollar of net revenues [= 5.35/152]. Ford's EBIT margin of 5.7% is considerably higher than that of GM (3.5%). Therefore, based on this single profitability measure, we would conclude that Ford has performed better than GM.
Comparison across companies: The "peer group"
When making comparisons across companies, one of the key challanges is the definition of the so-called peer group. Which companies are actually comparable? And which comparisons are actually "fair" (or meaningful)?
In the above example, our comparison included two companies (Ford and GM) that would seem to have similar business models. It would make little sense to compare Ford with Apple (EBIT margin of approximately 29%) or Pfizer (EBIT margin of approximately 24%) because these companies operate in completely different markets (for example, they sell different products, have better patent protection, etc.).
More generally, when defining the peer group, we should try to look for firms of similar:
- Line of business (industry)
- Size
- Growth
- Financing policy (capital structure)
- Age (Life cycle)
- Etc.
In many cases, because the number of potential comparables is fairly limited to begin with, analysts choose firms of similar size that operate in the same industry.
Comparisons over time
Also comparisons over time are not always straightforward. Restructuring activities such as mergers and acquisitions, divestitures, or spin-offs can significantly change the nature of the business, and so can the expiration of an important patent or the emergence of a new technology. All these "shocks" could imply that the financial statements of the past are no longer representative of the firm's current and future situation. To make meaningful comparisons, we would therefore have to adjust the historical financial statements.
In the next section, we discuss some of the key steps we should take to better understand a firm's financial situation.